Introduction to market failures (2024)

A complete failure

A complete market failure exists when free markets are unable to allocate scarce resources to the satisfaction of a need or want. This occurs because there are insufficient incentives to encourage profit-seeking firms to enter a market. This is commonly the case with pure public goods, such as street lighting, for which there is a need, but private individuals would not be prepared to pay. If no-one is prepared to pay, no revenue can be derived, and no profit earned; hence no firm would enter the market.

A partial failure

A partial failure can occur in four ways:

1. When some, but not all, of the necessary conditions for market formation exist. This means that markets form, but will fail to develop and supply sufficient quantities of a good or service. In the case of merit goods, such as education, markets are inefficient because they under-supply these goods, and fail to meet society’s demand.
2. When free markets over-supply a good or service, either because producers fail to take into account the full costs of production to society, or because consumers fail to take into account the full costs of consumption to themselves, or society. Externalities and demerit goods are cases of free markets over-supplying.
3. Where there is a breakdown in self-regulation, as in the case of the financial crisis.
4. Where a market becomes highly unstable and fails to return quickly to a stable equilibrium, as in the case of some commodity markets.

Some economists argue that all market failures are, in some way, the result of information failure.

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Types of market failure